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Senior Loan ETFs: Safe Funds for Yield Chasers?

by JT on May 16, 2012

Investors everywhere have a dilemma: take a risky bet for higher-returns or accept bond yields that barely keep pace with implied inflation. Historically, investors swap stocks for bonds for higher returns in exchange for a riskier portfolio.

The choice is no longer so binary, as safer high yield investments evolve. New senior loan ETFs make it possible for investors to chase high-yield bonds with floating rates that rise and fall with the market.

What are Senior Loans?

Senior loans are variable rate bank loans to businesses that are senior to bonds. Being senior, the loan is repaid first (even before bondholders) in the case of bankruptcy. Also, as senior notes are short-term financing products, senior notes carry a floating interest rate.

Senior loans are key to buyout and private equity transactions. In a buyout, companies accept variable rate, short-term loans to reduce their debt servicing costs. Senior loans are also known as leveraged loans as they are used primarily for the purposes of increasing cash returns for investors with the use of low-interest, short-term debt.

Two Choices in Senior Loan ETFs

Senior loan ETFs are still few and far between. Here is a list of ETFs available (or soon to be available) to investors:

PowerShares Senior Loan Portfolio (BKLN) – PowerShares launched a senior loan ETF to eager investors ready to snap up shares. The ETF took in some $358 million in assets, indicative of massive interest in high-yield debt. The fund has a 12-month yield of 4.62%, much higher than other bond funds sporting similar maturity dates. A 55-45% split in assets between loans maturing in 1-5 and 5-10 years puts it squarely in the intermediate bond fund category. Finally, net expense ratios tally to .76% after a .10% fee waiver.

SPDR Blackstone/GSO Senior Loan ETF (SRLN) – Recently approved by the SEC, Blackstone will partner with State Street to launch this new ETF tracking the performance of senior loans. The fund will seek outperformance by active management, looking to best the benchmark U.S. 100 Leveraged Loan index. Invested domestically and abroad, it will carry a .9% annual expense. As it tracks the same benchmark as the BKLN ETF, we should expect a very similar average maturity date.

The choice in funds is interesting: both the PowerShares and Blackstone funds intend to use the U.S. 100 Leveraged Loan index as a benchmark to their respective funds; however, Blackstone will look for outperformance by selection rather than passive tracking. The PowerShares ETF seeks only to mirror the index, rebalancing semi-annually in June and December to maintain a market-weighting consistent with the underlying index.

Can Leveraged Loans Win Out?

Leveraged loans are essentially a bet that inflation will run higher than expected by the market, but not high enough to significantly affect business operations. Since senior loans carry a floating-rate tethered to a market index, higher rates reward investors with fatter yields. However, if rates run too high due to inflation, firms borrowing with floating-rate loans risk default as debt servicing costs rise precipitously.

One would expect that both funds will hedge their bets to black swan-style inflation risk. Some leveraged and senior loans are issued with interest rate ceilings, but the ceiling exists only on a case-by-case basis. As leveraged loans are a specialty product, each contract and funding offer is written to suit the borrower – no two loans are exactly the same. The prospectus available for either fund allows for the use of credit default swaps and derivatives to mitigate some risks to investors.

Yield Comparisons between Bond ETFs

A good comparison for senior loan ETFs might be the Vanguard Intermediate-Term Corporate Bond ETF (VCIT), which yields only 3.21% annually. It carries a similar maturity profile; however it also has significant short-term risks to the principal amount in the event that interest rates rise. Also, the fund has a slightly-higher quality bond selection, though the bonds are not senior to other bonds in the event of bankruptcy and of course, the yields don’t approach those of junk bond ETFs.

Investors in “risk-free” US Treasuries at historic lows would have to extend out 30 years to get a return of 3.11%, a yield still lower than the yield in the above funds.

Senior Loans: The Bottomline Difference

The bottom line is this: floating-rates have excellent advantages. Investors with capital in senior loan funds can extend capital further down the yield curve for higher returns without the concern of loss stemming from bond convexity should rates push higher. Traditional bond ETFs would be expected to decline in value as rates rise.

One could reasonably expect to use a senior loan ETF to draw an income with strong principal protection. All in all, in a market where banks have only recently returned to issue new leveraged loans, investors are poised to pick up the slack and achieve returns greater than a similar maturity mix of corporate bonds with less intermediate risk. I find these new products extraordinary attractive as an alternative for yield-chasing investors.